Risk management and the cost of equity: evidence from the United Kingdom’s non-life insurance market

Abstract

We investigate the effect of risk management (reinsurance) on the corporate cost of equity using panel data drawn from the United Kingdom’s (UK) non-life insurance industry. Our results show that use of reinsurance lowers the cost of equity but that the relation is non-linear. We find that the rate of reduction declines as the level of premiums ceded relative to total gross premiums written increases. We also find that the reinsurance-cost of equity relation is moderated by the risk of financial distress/bankruptcy. This moderating relation is robust to the use of three alternative measures of financial distress and bankruptcy risk.

KEYWORDS:

• Risk management
• cost of equity
• reinsurance
• insurance
• bankruptcy
• UK

JEL CLASSIFICATIONs:

• G22
• G23
• G32

Acknowledgements

The comments of Dylan Thomas and Hong Zou are gratefully acknowledged. The paper also benefited from the comments of participants at seminars hosted by the Intercollegiate Accounting and Finance Colloquium, Gregynog and American Risk and Insurance Association. In addition, Vineet Upreti and Yihui Jia are grateful for the financial support of the Willis Research Network. Finally, the usual disclaimer applies.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 In 2016/17 there were 451 non-life insurers authorized to operate in the UK; however only approximately two-thirds of these entities actively underwrite and report insurance business. Non-active/non-reporting insurance operatives include a miscellany of structures, such as closed funds in run-off, ‘brass plate’ branches of European financial institutions with ‘passport rights’ to write (but not retain and report) business in the UK, and protection and indemnity pools that do not underwrite third party risks.

2 Since reinsurance is a binding contract, reinsurers will have to pay their share of losses irrespective of the level of financial leverage of the direct insurance writer. In contrast, increased leverage following a significant loss event will result in an increased risk of financial distress/bankruptcy, and therefore, a higher cost of capital for the primary insurer.

3 The FTSE-350 Non-life Insurance Index is a market-capitalization weighted index of all the companies in the non-life insurance sector of the FTSE 350 Index. The index was developed with a base value of 1,000 as of December 31, 1985. The FTSE-All-Share is a market-capitalization weighted index representing the performance of all eligible companies listed on the London Stock Exchange’s (LSE’s) main market, that pass screening for firm size and liquidity. The FTSE-All-Share Index covers approximately 98% of the UK’s total market capitalization.

4 A minority of the insurance firms included in our panel sample (e.g. Allianz) are quoted on the main stock exchanges based in the country of their respective parent companies (e.g. Germany). We treat corporate subsidiaries as stand-alone firms as they have to maintain the same capital maintenance standards under the UK’s insurance industry solvency regulations.

5 Unlike the ‘pure-play’ approach commonly used for cost of equity estimation, which discards conglomerates, the FIB approach includes conglomerate as well as specialist firms to identify the impact of various lines of business on the cost of capital (Cummins and Phillips, 2005).

6 The six major lines of insurance business that are used in this study are: personal accident; motor insurance; property insurance; liability insurance; marine, aviation & transport insurance; and miscellaneous and financial loss. Together, these main lines comprise over 90% of annual premiums written in the UK insurance market over the period of analysis.

7 The average betas of insurance firms tend to be less than 1.0 - the market mean measure of systematic risk in portfolio theory (Cummins and Phillips, 2005).

8 Leland (1999) suggests that the degree of risk aversion of a representative investor can be viewed as the ‘market price of risk’, and can be estimated by dividing the market’s instantaneous excess rate of return by the variance of the market’s instantaneous rate of return. Accounting for the effects of firm-level human capital and the mean reversion character of stock index, Campbell (1996) estimates the value of risk aversion parameter ‘b’ to be 3.63. For simplicity, Wen et al., (2008) use the nearest integer value of 4 in their calculations; we do the same in this study.

9 The insurance underwriting cycle reflects temporal changes in premium rates, profits and capital capacity. The cycle begins after periods of large across-sector losses when premium rates rise, thereby, increasing profits, and attracting inflows of capital into the non-life insurance sector. In competitive insurance markets, such as the UK, increased capital capacity deflates prices thus reducing insurers’ profitability.

10 We thank the anonymous referee for suggesting this definition of the Z-score.

11 Another commonly used test for endogeneity is the C-statistic, which is defined as the difference of two Sargan-Hansen statistic. Under the assumption of conditional homoskedasticity, this endogeneity test statistic is numerically equal to a Hausman test statistic (see Hayashi (2000), 233–234). With a test statistic of 2.25 (p-value of 0.13), the computed C-statistic test also accords with the result of the Durbin-Wu-Hausman test reported in panel B of Table 3.